Stocks to Buy in China’s Slowing Economy

The news out of China is gloomy—and may get worse. As Matthew C. Klein lays out in The Economy column, China faces long-term challenges of productivity and an aging population. But China is also wrestling with a significant economic transition that is happening right now.

And for investors, that shift is crucial. China isn’t just trying to jump-start its economy; it’s attempting to create a new economy—which will entail risk, while opening up new long-term investment opportunities.

China’s economy isn’t imploding, but the days of 10% growth are behind it. Economists expect roughly 5% growth—with some fund managers and more-bearish economists expecting it to settle even lower. The slowdown comes as China tries to wean itself off debt-fueled investments in infrastructure, housing, and other fixed assets, and to move beyond its role as the world’s factory to generate more sustainable growth from domestic consumption and innovation.

These latter factors will produce the next generation of winning investments.

The trade war and slowing global growth have complicated that shift. To prevent too swift a slowdown, China has backed off from steps it was taking to reduce debt by restraining credit expansion and increasing regulation, and in the process have sapped business confidence.

“In my 18 years in China, I have never seen the level of nervousness and pessimism that I have seen in the past nine months,” says Michael Pettis, a professor of finance at Peking University’s Guanghua School of Management and a nonresident senior fellow at the Carnegie Asia Program. But, he adds, “This is a good thing, not a bad thing. Ordinary Chinese people are fully aware that there must be changes in the way the economy is managed. The biggest opposition that [President] Xi Jinping faces is likely to be from local vested interests.”

Cheap valuations following 2018’s awful stock market performance and hope of a U.S. trade deal have drawn investors back into emerging market stock funds, which have seen 14 consecutive weeks of net inflows—the longest streak in 16 months, according to EPFR Global. The
iShares MSCI China
exchange-traded fund (ticker: MCHI) is up 5.5%.

But, wary of U.S.-China tensions and restructuring risks, fund managers are picking their spots carefully. They’re focusing on companies that can prosper from—or at least weather—shifts in the economy and consumer preferences, as well as on areas that China is investing in for its future, like technology and health care.

Whatever China’s “new normal” growth level is, the economy is slowing and wage gains—key for spending—are softening, with disposable income for urban residents climbing 5.6% last year, from 6.5% in 2017. The slowdown is a major change for a generation of Chinese who have known only rising incomes and growth, says Justin Leverenz, who manages the $38 billion top-performing
Oppenheimer Developing Markets
fund (ODMAX). He has been buying Chinese stocks in the selloff, but remains underweight because of the risks.

Former engines of growth like the property market—and ancillary sectors like financials and real estate—are slowing, Leverenz adds. Auto and appliance sales have been clobbered and may not fully recover, since property, auto, and appliance purchases tend to go together, he says. The same goes for material companies, if China leans less on debt-fueled investments.

So, Leverenz is focusing on “new China” companies using technology to disrupt or create industries. One is recently public
Meituan Dianping
(3690.Hong Kong), which derives part of its business from food delivery and the rest from being what Leverenz calls “the Alibaba for services,” helping brick-and-mortar companies with marketing, supply chain, and customer-relationship management. “These companies are taking market share from less-efficient players. Lower GDP growth doesn’t have the same dramatic impact on them as ‘[on] old China’ companies [for which] profit cycles are tied to pricing, and deflation is now the worry,” Leverenz maintains.

Services have been a bright spot in China’s economic data, with a private market survey in December showing their strongest growth since June. Tiffany Hsiao, co-manager of
Matthews China Small Companies
fund (MCSMX), sees big potential in the Chinese software outfits behind services like cloud computing; a stock she favors is data provider
Kingdee International Software Group
(268.Hong Kong). “There is tremendous opportunity for those providing software to improve productivity or helping with recruiting, and we see growth there despite all the uncertainty,” Hsiao says.

Investors and global companies alike have chased after China’s consumers. Near-term, economic weakness and layoffs could dent household income and curtail spending, but consumption growth is expected to be on par with that of the U.S. and Western Europe combined through 2030, according to a recent McKinsey Global Institute report.

Consumer preferences, however, are changing. For example, consumers are increasingly spending more on services, like private education, travel, and even beauty treatments. They’re also less fixated on buying marquee brands to showcase their wealth, especially if a cheaper product offers the same functionality—as
Apple
(AAPL) has learned. While the iPhone is seen as a fashion statement, Leverenz says, phones from Chinese rivals, such as privately held Huawei and
Xiaomi
(1810.Hong Kong), are more commonly found in the pockets of mainstream consumers. Locals are also gaining ground in lodging. U.S. chains and multinationals invested aggressively in China, targeting the affluent, but now face high vacancy rates and little pricing power, Leverenz observes. Meanwhile,
Huazhu Group’s
(HTHT) China Lodging , which focuses on the much bigger pool of more price-sensitive customers, is growing strongly.

The Chinese are also willing to pay more for quality on some items. “A decade ago, I wouldn’t have thought Chinese consumers would be buying music and movies. Fake DVDs were everywhere. But they are now paying for high-quality streaming content,” says Michael Oh, manager of the
Matthews Asia Innovators
fund (MATFX). Among his holdings is
iQiyi
(IQ), a video-streaming company that Oh compares to
Netflix
(NFLX).

To get its citizens to spend more to boost consumption, China has to help create safety nets by supporting education and health care. Expanding universal health care is one of the government’s priorities, as a quarter of its population will be over 60 by 2030. “Chinese companies positioning themselves to address domestic issues will be the most successful,” says Alberto Fassinotti, who oversees $3 billion in assets as a portfolio manager for emerging markets at Rock Creek Group. He has used the selloff to focus on such companies, including drugmaker
China Medical System Holdings
(867.Hong Kong) and medical-device manufacturer
Shandong Weigao Group Medical Polymer
(1066.Hong Kong).

China’s transition comes with plenty of risk. While its debt weighs heavily on the market, Fassinotti and others worry about unemployment if the services industry can’t absorb the layoffs in manufacturing. “It is putting inordinate pressure on Xi to get this fixed,” Fassinotti says. “Our biggest concern is that his own allies start to turn against him if they see their interests threatened by this slowdown.”

In the short term, the risks could ramp up pressure for a trade deal, more stimulus—or both. But kicking the can down the road only makes China’s debt more dangerous—a reason those buying Chinese stocks are going slow.

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